Moody’s: W. European economic resilience boosts high-yield credit quality

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Vigorous economic growth in Western Europe has strengthened business sales and more than offset the impact of higher interest rates, giving an unexpected boost to credit quality, Moody’s Investors Service said in a new Special Comment.

In a surprise development, it was speculative-grade, non-financial issuers that underpinned overall credit quality in the second quarter of 2007, accounting for a disproportionate share of positive rating revisions.

The majority of these upgrades were prompted by successful de-leveraging and solid operating performances — results that may appear counterintuitive given the tighter interest rate conditions.

“A mix of favourable factors explains why the speculative-grade, non-financial sector has borne up so well. Moody’s expects, however, that, as the self-reinforcing up-cycle withers in the face of wider spreads and increasing risk aversion, the buoyant dynamic in speculative-grade credit quality will unwind,” noted Paul Guest, Chief European Economist and report co-author.

The turnaround in overall Western European credit quality occurred more rapidly and more vigorously than anticipated, with benign economic conditions, relatively low gearing in the overall corporate sector, better-than-expected revenue inflows and favourable financing conditions all contributing to the unexpected improvement.

Upgrades outnumbered downgrades by the broadest margin since the fourth quarter of 2004, although this was entirely driven by the speculative-grade, non-financial component.

In the investment grade, developments were less favourable: M&A activity is exerting a modestly negative influence on the credit cycle, a feature reinforced by the current rating review statistics. Takeovers and leveraged acquisitions will continue to undermine credit quality among investment-grade issuers, although Moody’s does not expect this to persist. Strong fundamentals and diminished event risk will ultimately redress this segment in favour of upgrades.

Nor will the favourable financing conditions for speculative-grade issuers persist.

Weaknesses in the high-yield market have started to appear, as Christine Li, co-author of the report, warned: “In good times, abundant liquidity and demand for riskier assets allows debt-laden issuers to refinance with ease. Increasing risk aversion results in a  move away from riskier to higher-quality assets, making it increasingly difficult for over-leveraged firms to operate.”

She added, however, that “although there has been an increase in risk aversion and spreads have consequently widened, they remain at historically low levels”.

Looking ahead, the preponderance of reviews for possible downgrade implies that negative rating actions will outnumber positive actions in the third quarter. “Given that the overwhelming majority of issuers on review for possible upgrade in the second quarter were investment-grade, financial-sector issuers that Moody’s believes will handle the lagged impact of past and future interest rate hikes better than their speculative-grade, non-financial counterparts, the sharp improvement in high-yield credit quality is unlikely to last,” concludes co-author Dr. Matthew Cairns.

The Moody’s special comment — entitled “European Credit Trends Q2 2007” — also discusses credit quality in Eastern Europe. Excluding sovereign-related rating actions, there were just three rating actions in the region in the second quarter, comprising two upgrades and one downgrade. However, sustained rapid growth and income convergence are steadily broadening the array of issuers affected, away from the traditional dominance of sovereigns and financial-sector firms.